The New Estate-Planning Environment

Adverse Changes

It is important to note that while most or all media attention focused on the potential drop of the gift and estate tax exemption to $1 million and the increase in the rate to 55%, there were other even more adverse changes that the wealthy feared might occur in 2013. A few of these are important to note because they did influence how many of the large 2012 transfers were made.

Discounts

Valuation discounts may have been restricted or eliminated. In a nutshell, these discounts permit the valuation of a non-controlling interest in an entity to be transferred at a value less than the proportionate value. So a 30% interest in a limited liability company (LLC) would be valued at much less than 30% of the value of LLC's property or aggregate value. The impact of this was that many wealthy clients transferred discounted interests in entities to trusts in 2012 to lock in discounts before they were changed. While they were not changed at the beginning of the year, it is possible that future legislation may restrict them. Future divorce cases are far more likely than ever before to have to contend with shareholders, partners and members that are irrevocable trusts.

Generation Skipping Transfer

Allocation of generation skipping transfer (GST) tax exemption may have changed. In very simplistic terms, if a client transfers assets to grandchildren (skip persons in tax jargon, or trusts for them) a second tax in addition to the gift or estate tax may be assessed once the exemption is exceeded. The exemption was $5,120,000 in 2012 ($5 million as inflation adjusted). This figure was slated to drop precipitously to $1 million inflation adjusted in 2013. Just as significantly, President Obama has proposed limiting the duration for which transfers to trusts can be removed from the tax system by an allocation of the GST exemption to 90 years. Before that legislation may be enacted, it is possible to allocate GST exemption to protect assets transferred to a trust formed in a jurisdiction that does not limit the duration of trusts (or has a very long period) so that assets could conceivably grow in that trust free of gift, estate or GST tax forever. The combination of these two adverse changes motivated astute wealthy taxpayers to make 2012 transfers to trusts that would continue for long durations or in perpetuity.

Grantor Trusts

This complex tax concept was likely never discussed outside publications targeted to the estate planning professional, yet it was ' and so far remains (although future legislation may change this) ' the most powerful wealth-shifting mechanism for the wealthy. President Obama, seeking to have wealthy taxpayers bear a greater share of the tax burden, proposed eliminating this benefit by having grantor trusts formed, or funded, after the date of restrictive legislation, included in the grantor's estate. Fearing this restriction and the resulting strangulation of some of the most powerful planning techniques, wealthy taxpayers by the droves formed and funded grantor trusts in 2012.

Why are these types of trusts so powerful? First, the income earned by a grantor trust is taxed to the client/grantor. This is a tremendously powerful leveraging tool. Over the years, income can accrue inside the trust while the client's estate is diminished by the payment of the income taxes on income the client does not have. If the ex-spouse is a beneficiary of the grantor trust, the marital estate could be reduced year by year as the assets in the trust increase. While this may raise issues as to whether marital property was used to pay the income tax on a trust for which one spouse was not the beneficiary, extracting funds from the trust to address that may be far more difficult than ever before (see “DAPT Jurisdictions” below).

The second application of grantor trusts for the very wealthy client is even more substantial. Once a trust is formed and funded with perhaps $5 million in gifts, the client could sell interests in a family business to the trust, worth perhaps $50 million. These discounted business interests could appreciate inside the trust while the low interest note that the client received in exchange may be a difficult marital asset to address in a divorce. These notes bore interest at the very low rates that existed in 2012. If, in a later divorce, such a note were divided, the interest the spouse would receive might be quite insignificant relative to what future interest rates will be. There are a number of significant aspects to this planning in divorce matters. Substantial assets were transferred to these trusts in 2012 to capture these benefits before their possible repeal (which as of April 2013 had not happened). Thus, as noted above, matrimonial practitioners will likely face “marital” estates with a substantial portion of the wealth held in irrevocable grantor trusts.

There is a flip side to this planning. The grantor trust status could prove to be the proverbial double-edged sword. While one side was a great estate-planning tool, in a divorce scenario, the continuation of grantor trust status in some cases could result in one ex-spouse paying income taxes on income inuring to the benefit of the other ex-spouse. Any matrimonial matter that includes a trust should first have an estate-planning expert evaluate the trust, ascertain its tax status, and if the trust is a grantor trust, determine when and how that status may end. If your client will bear an income tax cost on income he or she cannot control or perhaps not even benefit from, that should be factored into the negotiations. The continuation or termination of grantor trust status will be a key issue in many divorces.

One final point. Many trusts achieve grantor trust status by giving the client/grantor the right to swap assets of the trust. So never assume without investigation what assets are actually owned by the trust. The old presumption of assuming what was reported on Schedule A or reflected on the last tax return is still in the trust, could be mistaken.

Domestic Asset Protection Trust (DAPT) Jurisdictions

For many wealthy clients, the above factors resulted in transfers being made to irrevocable trusts formed in the four most trust-friendly states: Alaska, Delaware, Nevada and South Dakota. In order for a client domiciled in another state to form a trust in one of these jurisdictions, an institutional trustee had to be ' or generally was ' named. Future matrimonial actions will likely have to contend, to a dramatically greater degree than ever before, with trusts in these jurisdictions. This will not only present logistical and choice of law issues, but these jurisdictions will likely have more divorce-protective rules for trusts than the client's home state. Further, institutional trustees will rarely manage trusts in the haphazard manner ignoring trust terms and formalities that most family trustees commonly do. Thus, the mistakes that have often helped either unravel family trusts or at least negotiate better settlements may all be absent. The challenges will prove substantial to ex-spouses seeking any benefit from these transfers.

Martin M. Shenkman, CPA, MBA, PFS, AEP, JD, a member of this newsletter's Board of Editors, is an attorney in private practice in Paramus, NJ, and New York City.

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Two recent events have dramatically changed the face of estate planning and each will have a significant impact on divorces for years ' likely decades ' in the future. This article explores each of these two factors, identifies some of the changes relevant to matrimonial practitioners, and suggests practical steps that might be taken to address them.

2012 Gift Transfers Will Affect Matrimonial Cases

In 2012, wealthy Americans by the droves made gifts, often to irrevocable trusts, to lock some or all of the $5.12 million gift tax exemption that most feared would disappear in 2013. While the exemption was not reduced, the massive gift transfers that occurred in the last portion of 2012 will have a significant impact on matrimonial cases for years to come. As one informal measure of the wealth transferred, it has been estimated that in excess of 500,000 gift tax returns were filed for 2012, which is a dramatic increase over prior years. This article describes the range of planning and focuses on how to plan better, as matrimonial practitioners will likely have to evaluate these plans in future divorce cases. Then, some of the implications for matrimonial practitioners are discussed.

Adverse Changes

It is important to note that while most or all media attention focused on the potential drop of the gift and estate tax exemption to $1 million and the increase in the rate to 55%, there were other even more adverse changes that the wealthy feared might occur in 2013. A few of these are important to note because they did influence how many of the large 2012 transfers were made.

Discounts

Valuation discounts may have been restricted or eliminated. In a nutshell, these discounts permit the valuation of a non-controlling interest in an entity to be transferred at a value less than the proportionate value. So a 30% interest in a limited liability company (LLC) would be valued at much less than 30% of the value of LLC's property or aggregate value. The impact of this was that many wealthy clients transferred discounted interests in entities to trusts in 2012 to lock in discounts before they were changed. While they were not changed at the beginning of the year, it is possible that future legislation may restrict them. Future divorce cases are far more likely than ever before to have to contend with shareholders, partners and members that are irrevocable trusts.

Generation Skipping Transfer

Allocation of generation skipping transfer (GST) tax exemption may have changed. In very simplistic terms, if a client transfers assets to grandchildren (skip persons in tax jargon, or trusts for them) a second tax in addition to the gift or estate tax may be assessed once the exemption is exceeded. The exemption was $5,120,000 in 2012 ($5 million as inflation adjusted). This figure was slated to drop precipitously to $1 million inflation adjusted in 2013. Just as significantly, President Obama has proposed limiting the duration for which transfers to trusts can be removed from the tax system by an allocation of the GST exemption to 90 years. Before that legislation may be enacted, it is possible to allocate GST exemption to protect assets transferred to a trust formed in a jurisdiction that does not limit the duration of trusts (or has a very long period) so that assets could conceivably grow in that trust free of gift, estate or GST tax forever. The combination of these two adverse changes motivated astute wealthy taxpayers to make 2012 transfers to trusts that would continue for long durations or in perpetuity.

Grantor Trusts

This complex tax concept was likely never discussed outside publications targeted to the estate planning professional, yet it was ' and so far remains (although future legislation may change this) ' the most powerful wealth-shifting mechanism for the wealthy. President Obama, seeking to have wealthy taxpayers bear a greater share of the tax burden, proposed eliminating this benefit by having grantor trusts formed, or funded, after the date of restrictive legislation, included in the grantor's estate. Fearing this restriction and the resulting strangulation of some of the most powerful planning techniques, wealthy taxpayers by the droves formed and funded grantor trusts in 2012.

Why are these types of trusts so powerful? First, the income earned by a grantor trust is taxed to the client/grantor. This is a tremendously powerful leveraging tool. Over the years, income can accrue inside the trust while the client's estate is diminished by the payment of the income taxes on income the client does not have. If the ex-spouse is a beneficiary of the grantor trust, the marital estate could be reduced year by year as the assets in the trust increase. While this may raise issues as to whether marital property was used to pay the income tax on a trust for which one spouse was not the beneficiary, extracting funds from the trust to address that may be far more difficult than ever before (see “DAPT Jurisdictions” below).

The second application of grantor trusts for the very wealthy client is even more substantial. Once a trust is formed and funded with perhaps $5 million in gifts, the client could sell interests in a family business to the trust, worth perhaps $50 million. These discounted business interests could appreciate inside the trust while the low interest note that the client received in exchange may be a difficult marital asset to address in a divorce. These notes bore interest at the very low rates that existed in 2012. If, in a later divorce, such a note were divided, the interest the spouse would receive might be quite insignificant relative to what future interest rates will be. There are a number of significant aspects to this planning in divorce matters. Substantial assets were transferred to these trusts in 2012 to capture these benefits before their possible repeal (which as of April 2013 had not happened). Thus, as noted above, matrimonial practitioners will likely face “marital” estates with a substantial portion of the wealth held in irrevocable grantor trusts.

There is a flip side to this planning. The grantor trust status could prove to be the proverbial double-edged sword. While one side was a great estate-planning tool, in a divorce scenario, the continuation of grantor trust status in some cases could result in one ex-spouse paying income taxes on income inuring to the benefit of the other ex-spouse. Any matrimonial matter that includes a trust should first have an estate-planning expert evaluate the trust, ascertain its tax status, and if the trust is a grantor trust, determine when and how that status may end. If your client will bear an income tax cost on income he or she cannot control or perhaps not even benefit from, that should be factored into the negotiations. The continuation or termination of grantor trust status will be a key issue in many divorces.

One final point. Many trusts achieve grantor trust status by giving the client/grantor the right to swap assets of the trust. So never assume without investigation what assets are actually owned by the trust. The old presumption of assuming what was reported on Schedule A or reflected on the last tax return is still in the trust, could be mistaken.

Domestic Asset Protection Trust (DAPT) Jurisdictions

For many wealthy clients, the above factors resulted in transfers being made to irrevocable trusts formed in the four most trust-friendly states: Alaska, Delaware, Nevada and South Dakota. In order for a client domiciled in another state to form a trust in one of these jurisdictions, an institutional trustee had to be ' or generally was ' named. Future matrimonial actions will likely have to contend, to a dramatically greater degree than ever before, with trusts in these jurisdictions. This will not only present logistical and choice of law issues, but these jurisdictions will likely have more divorce-protective rules for trusts than the client's home state. Further, institutional trustees will rarely manage trusts in the haphazard manner ignoring trust terms and formalities that most family trustees commonly do. Thus, the mistakes that have often helped either unravel family trusts or at least negotiate better settlements may all be absent. The challenges will prove substantial to ex-spouses seeking any benefit from these transfers.

Martin M. Shenkman, CPA, MBA, PFS, AEP, JD, a member of this newsletter's Board of Editors, is an attorney in private practice in Paramus, NJ, and New York City.

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